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The Rise of Low-Cost Passive ETFs and Their Impact on Active Portfolio Management: Implications for Institutional Manager Selection

  • Writer: Ankit Dahiya
    Ankit Dahiya
  • Apr 30
  • 3 min read

Updated: Apr 30




1. Introduction

The asset management industry has undergone a seismic shift over the past decade, driven by the explosive growth of low-cost passive ETFs. This case study examines how this trend has disrupted active portfolio management and reshaped institutional strategies for hiring external managers. Drawing on data from academic research, industry reports, and market analyses, we explore the implications of passive investing dominance and the evolving role of active strategies in a transformed ecosystem.


2. Context: The Passive ETF Revolution

Key Trends

  • Market Penetration: Passive ETFs now account for 48% of U.S. investment fund assets, up from 19% in 2010, with global AUM surpassing $14.7 trillion in 2024.

  • Cost Efficiency: Average expense ratios for passive ETFs are 11–22 basis points lower than active mutual funds, driven by structural advantages like automated rebalancing and reduced trading costs.

  • Performance: Over 80% of active equity funds underperformed benchmarks post-fees in the last decade, accelerating the shift to passive strategies.

Drivers of Growth

  • Regulatory changes (e.g., fiduciary duty rules, fee transparency mandates).

  • Rise of robo-advisors and digital distribution channels.

  • Investor preference for predictable returns amid market volatility


3. Disruption of Active Portfolio Management

Challenges for Active Managers

  • Fee Compression: Passive ETFs have normalized low fees, pressuring active managers to justify higher costs. For example, active equity ETFs now charge ~0.50% vs. 0.10% for passive counterparts.

  • Performance Scrutiny: Only 31% of active large-cap funds outperformed passive peers in 2024, eroding confidence in alpha generation.

  • Market Distortions: Passive strategies amplify price correlations and overvaluation risks, particularly in mega-cap indices like the S&P 500, reducing opportunities for stock-picking.

Case Example: The "Closet Indexing" DilemmaMany active funds now mimic benchmark indices to avoid underperformance-triggered outflows, blurring the line between active and passive management. Cremers et al. (2016) found "closet indexing" is as prevalent as explicit indexing in some markets


4. Institutional Adaptation Strategies

Shifts in Manager Selection Criteria

  1. Active Share Focus: Institutions prioritize funds with >80% active share to avoid closet indexers

  2. Niche Expertise: Demand surges for managers specializing in high-dispersion markets (e.g., small caps, emerging equities) where passive strategies struggle

  3. Hybrid Models: Blending passive ETFs (e.g., S&P 500 core holdings) with active satellite positions (e.g., thematic or ESG-focused ETFs) to balance cost and alpha

Emergence of Active ETFs

  • Active ETFs now represent 8% of U.S. ETF AUM, with 97% of institutional investors planning to increase allocations in 2025. These vehicles offer intraday liquidity and tax efficiency while enabling tactical shifts, such as defensive sector tilts (e.g., utilities via XLU)


5. Challenges and Risks

  • Overvaluation Loops: Passive flows disproportionately inflate mega-cap stock prices, creating systemic risks. For instance, S&P 500 constituents experience heightened volatility due to index-driven demand.

  • Hidden Costs: Licensing fees for index providers (e.g., S&P Dow Jones) account for up to 25% of ETF expense ratios, limiting fee-reduction potential.

  • Reduced Diversification Benefits: Indexing increases stock co-movement, diminishing the risk-mitigation advantages of diversification.


6. Future Outlook and Recommendations 2610

Macro Shifts in Public Equity Manager Selection

  • Cycle Awareness: Institutions favor managers adept at navigating cyclicality, such as those outperforming in high-dispersion periods (e.g., 2000–2009).

  • Innovation Imperative: Active managers must integrate AI-driven analytics and alternative assets (e.g., private credit, digital currencies) to differentiate.

  • Regulatory Tailwinds: Regulatory approvals for semi-transparent active ETFs and mutual fund-to-ETF conversions will further disrupt traditional models.

Strategic Recommendations for Institutions

  1. Adopt a dual mandate: Passive core + active satellites.

  2. Prioritize transparency in fee structures and alpha attribution.

  3. Leverage white-label ETF platforms for cost-efficient active strategy deployment.


7. Conclusion

The rise of passive ETFs has irrevocably altered the investment landscape, forcing institutions to rethink manager selection, fee structures, and risk management. While passive strategies dominate beta exposure, active managers must redefine their value proposition as specialists in inefficiency and innovation. Institutions that embrace hybrid models, demand niche expertise, and incentivize fee discipline will be best positioned to thrive in this new equilibrium.


Sources Cited

 
 
 

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